The stratospheric rise in value of bitcoin, the cryptocurrency and digital payment system, has captivated the financial press — and investors.
Don’t let your clients join the starstruck crowd.
Launched in 2009, bitcoin’s transactions are verified through a network of nodes and recorded in a publicly distributed ledger called a blockchain. It is a peer-to-peer system where users can place transactions with one another without the use of an intermediary. Bitcoin’s proponents argue it is a viable, more private, and more secure alternative to the world’s major reserve currencies.
But do these attributes make bitcoin a good investment or currency?
No, they do not. Bitcoin is in fact an exceptionally poor currency that doesn’t meet three basic requirements to be considered viable.
- It doesn’t serve as a medium of exchange.
Supposedly around 100,000 vendors around the world accept bitcoin, but anyone planning to conduct business globally would be well-advised to continue using traditional currencies for commercial transactions. Most of the businesses that do accept bitcoin quickly convert the cryptocurrency to dollars.
- Bitcoin doesn’t serve as a unit of account.
To be considered a currency, goods and services would have to be priced in bitcoin. We’re not there yet by any means.
Given the unregulated nature of bitcoin, irreversible transactions and the fact that it undercuts fees earned by financial intermediaries, bitcoin faces major hurdles to serving as a unit of account — and financial institutions have little incentive presently to facilitate bitcoin’s rise as a unit of account.
- The cryptocurrency is not a reliable store of value.
Bitcoin is highly volatile, and while much of this volatility has on the upside recently, volatility is not the hallmark of a reliable currency.
Imagine if the value of your checking or savings accounts rose 500% over the course of a year as a result of currency fluctuations. Conversely, imagine if your mortgage and credit card balances suddenly ballooned 500%. While an appreciating currency is great for lenders, it’s ruinous for borrowers. Healthy economies require stable, reliable currencies that work for both lenders and borrows, not just one or the other.
- What’s more, bitcoin is an exceptionally poor investment.
Bitcoin’s recent returns by themselves tell us nothing about whether or not the digital currency makes a good investment on a forward-looking basis. Investable assets produce future expected cash flows, which are critical inputs in any valuation model. Recall the basic valuation formula that states the present value of an asset is (or should be) the present value of its discounted future expected cash flows.
To be fair, just because bitcoin doesn’t generate free cash flows in the traditional sense doesn’t mean its investors don’t expect a future cash flow at some point. After all, early stage venture capital firms will often invest in start-ups with no assets or cash flows. They do so on the belief, based on extensive due diligence, that they will generate future cash flows, even if only a single cash flow, upon exit.
Buyers of bitcoin aren’t very different from venture investors — except for the extensive due diligence part. They expect a single cash flow upon sale in the future. This expectation assumes the digital currency’s upside momentum continues until it’s sold. In this sense, bitcoin can be thought of similarly to an early stage venture investment — as a start-up asset with a single, hoped for, future expected cash flow.
- Investing in bitcoin requires a collective belief, one not predicated on any tangible evidence, that someone in the future will be willing to pay more for the cryptocurrency than today.
This is the Greater Fool Theory. The bitcoin thesis assumes momentum continues indefinitely. Volumes of academic research, however, show that herding comes and goes, often unexpectedly, over varying time horizons. Momentum is anything but continuous and often experiences violent crashes.
Given its lack of cash flows, the absence of which requires investors to unrealistically rely on continuous price momentum to realize future returns, your clients should avoid bitcoin.
Article Published by Financial Planning November 28, 2017
Written by Donald Calcagni